Lease reform: A capital idea that doesn't go far enough

Our previous column reviewed the improvements in financial reporting that will follow from a new standard requiring capitalization of all material leases. When that reform is implemented, it will replace a 30-year-old standard with practices that should have been put in place, well, 30 years ago.As we described, moving to capitalization will have many effects, the most obvious being the introduction of a new liability to the lessee's balance sheet. It will also put a new asset into the base of the reported return on assets ratio at an amount that currently cannot be estimated from the footnote.

Capitalization will also move amounts around in the income statement and cash flow statement. Specifically, rent expense will be disaggregated into interest and depreciation, thus increasing the reported EBITDA; this change will also increase operating margins by moving the interest component from operating to financial income. In terms of cash flow, the reform will increase the reported operating cash inflow while increasing the reported financing cash outflow.

There is every reason to expect that a new standard will drive managers away from uneconomical lease contracts that will no longer offer a chance to spiff up the balance sheet. We anticipate that this development will eventually dry up the leasing industry, especially the large segment that was supported by its ability to provide deceptive reporting through off-balance-sheet financing.

Not enough

Despite this array of profound effects, however, moving to capitalization involves merely replacing a very outdated accounting method with another that is just about as outdated. As we see it, current board members should not just close the loopholes created by their counterparts in the 1970s. Instead, today's Financial Accounting Standards Board - and the International Accounting Standards Board, for that matter - need to look at leases in light of modern capital markets' needs for useful information that allows financial statement users to assess the amount, timing and uncertainty of future cash flows.

Like capitalization, the reform we're about to describe will change lessees' balance sheets, income statements and cash flow statements. It will also change management behavior even more than capitalization.

The balance sheet

While capitalization sets a course of major improvement by adding lease assets and liabilities, we take issue with the amounts that appear on the balance sheet. Specifically, the traditional approach to capitalization recognizes the asset at its original cost, which then gets allocated straight-line to expense over its predicted useful life. The liability is also recorded at its original balance, and then carried forward at amounts that equal the present value of the future cash flows discounted at the initial interest rate. Both practices are pitifully old and obsolete remnants of accounting from the 20th century that have outlived any usefulness they ever might have had.

More useful information would be provided to the markets if the leased assets were reported at their current market values, instead of their book values. That is, market-based numbers will provide statement users with insights into potential cash flows to be gained from those assets.

To anticipate the obvious objection, we expect these market values to be somewhat elusive, because the lessee's asset is the right to use the lessor's property. As a result, there may not be much data to draw on for estimating the value.

The usual response of accountants to this uncertainty has been to retreat to reporting the undepreciated cost. However handy that number might be, it has no usefulness for predicting future cash flows. In effect, it is another case where suppliers provide what they want to supply, instead of what consumers demand. Of course, that approach is a guaranteed recipe for failure.

Like all other debts, lease liabilities' current values can be (and already are) estimated by discounting the expected future cash flows at current market interest rates. Generally accepted accounting principles disclosures provide these amounts, so it would be only a small step to require them to be recognized on the balance sheet.

The income statement

Expenses traditionally associated with capitalized leases are systematically allocated depreciation and interest. With a move to market-based accounting, these costs will not be allocated, but will be measured by comparing the beginning and ending values of the lease asset and liability. This greater reform will create more usefulness, because it substitutes economically significant real numbers in the place of the imaginary numbers reported under GAAP.

One consequence will be greater variability, even volatility, in reported earnings. This outcome will surely agitate managers who like to report smooth numbers every chance they get, even if they have to fabricate them with systematic allocations. As we described, they will also be quick to claim that they can't produce these numbers with any reliability.

That second response begs this question: If managers don't know what the assets and liabilities are worth, then why on earth did they sign the lease contracts in the first place, and why do they continue to leave them outstanding? We simply don't buy this excuse, because it is rooted in ignorance. The time has come to stop giving managers a pass for reporting what they want to report, instead of what the markets need to make better decisions.

The cash flow statement

Since we're pondering what financial statements would look like when market values are reported, we're going to go further by hoping that cash flow statements will eventually be prepared using the direct method of displaying the cash from operations.

Under the market value approach, the cash flow statement will still report cash outflows equal to the lease payments. They will still be divided between operating and financing to reflect the interest and principal reductions, although the amounts will differ, reflecting adjustments for changes in market interest rates.

Management behavior

If value-based accounting were to be applied to leases, we would expect managers to change their behavior even more drastically. Specifically, the uncertainty and volatility associated with leases would be revealed in such a way that managers would be held accountable for the risks that they're taking but not reporting, even under capitalization.

Another behavior that we would expect to disappear is the propensity to insert various arcane provisions into leases, such as bargain purchase options, guaranteed residual values, executory costs, rent accelerators, contingent rentals and the like. These things have been created primarily for their ability to generate fog surrounding lease assets and liabilities. When there is no accounting "advantage" from this silliness, we expect it to just fade away.

Will it happen?

Of course, we're not oblivious to the revolutionary nature of our proposition for reporting market values. Will FASB be willing to consider going in this direction? Probably not, simply because of opposition from management and auditors and everyone else who cannot handle changes in the status quo.

If so, then why would we go to the trouble to describe a method that's unlikely to become generally accepted? It's as simple as this: We don't want anyone within the reach of this column to be satisfied when all leases are capitalized. We especially don't want our friends at the board to feel that they have accomplished a great deal by bringing accounting practice up to the level it could and should have achieved in 1976.

In addition, we don't want statement users to mistake capitalized lease numbers for what they really need to make better decisions in the markets. Don't get us wrong - capitalization is better than no change at all. Just not much better.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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